The interest rate charged to a borrower can be described as the cost of borrowing money. It is the farm lender’s compensation for servicing a loan and bearing the risk of lending. The interest rate is the borrower’s cost for the ability to spend now, rather than save the money and make a purchase later. If a borrower had to wait until they saved the money for the purchase, they would often have to defer opportunities that could possibly generate future cash flow. The ability to borrow money and have it now also allows borrowers to take advantage of opportunities that are currently available that may not be available in the future. Many times, the interest a borrower pays to obtain the money now is less than the cost of forgoing a missed opportunity.
Many factors affect the interest rate on a real estate loan: length of the note, type of loan product, collateral offered as security, repayment ability, supply and demand of credit, and the government’s monetary policy.
While we have very little control over government and economic activity, there are a few factors that a borrower should understand.
1) Maturity Date The longer period of time between the origination and the maturity of the farm loan will cause the interest rate to increase. This is partly due to the time value of money and inflation. The dollar will presumably buy less in 20 years than it will today.
2) Loan Product Interest rates vary with the type of farm loan product a borrower obtains. Loan products can have a fixed, adjustable, or variable interest rate. A fixed rate carries the same interest rate throughout the life of the loan. It offers a borrower some stability in knowing that the payment requirements will not change. An adjustable rate sets intervals in which the interest rate changes, such as every 3, 5, or 10 years. A variable rate also sets intervals in which the interest rate may change but it can be at the discretion of the lender. An adjustable or variable rate farm loan product usually offers lower interest rates.
3) Collateral Collateral is what the farm lender uses as security for a loan. If a borrower is obtaining a loan for farm real estate, the lender will usually put a mortgage on that farm property to serve as security. However, collateral offered as security does not have to be restricted to only property that is being purchased. The farm lender can take a mortgage on land the borrower already owns, in addition to the property being purchased, to serve as additional collateral.
4) Credit Score A borrower’s credit score tells the farm lender how the borrower has handled money in the past. It also tells the farm lender what other financial obligations the borrower currently has and if that might impact the borrower’s repayment ability in the future.
The above factors are just pieces to the overall puzzle. Each factor alone does not constitute what an interest rate might be set as. Farm lenders consider all the pieces and how they interrelate to determine the interest rate on a loan product. The borrower who understands the factors that affect the interest rate will be in a better position to gain the biggest advantage with their borrowing needs.